Aspen Trading Group: Chinese IPOs - A Little Like Russian Roulette?

It can be like roulette if you do not nail the timing. We, as well as Aspen clients, are long IQ, the recent IPO ...

Chinese IPOs - A Little Like Russian Roulette?

It can be like roulette if you do not nail the timing. We, as well as Aspen clients, are long IQ….the recent IPO from $18.59….last traded $31….a +67% gain. We are thrilled with this trade. Brad’s excellent valuation and deep dive into their business model illuminated a great set-up.

​

The key question is what to do now? With the rapid price appreciation of IQ it is easy to get a bit ‘comfortable’ and simply expect more of the same. However, some simple comparative analysis is useful and might provide a sensible and thoughtful trade management approach.

What Could Go Wrong?

There is nothing like a successful trade to give a trader a dangerous dose of overconfidence. Instead ask, “What could go wrong”? Let’s step back and take a look at previous Chinese IPO stocks (even the best of them) and see how they have performed in their early days.

The stocks selected for this chart are mid to mega cap stocks that have tended to go up shortly after their IPO and are currently in good financial health. They are legitimate, strong Chinese companies that trade well today. The chart shows how a $100,000 investment would have performed for these five companies in the first 200 days of trading.

The chart makes it clear that even after a positive start, there is not one stock that goes straight up. Some of the companies produce incredible returns in the first 60-90 days, and then they give a lot of it back. It’s not exactly Russian roulette, but caution is warranted.

Some may recall BABA just a few years ago. There was a lot of hype around BABA at its IPO. Today it trades well above its IPO price. But as the chart shows, it was not a smooth ride, especially in the first 200 days of trading. Also, WUBA produced some fantastic returns at the beginning and then it too gave much of the gains back.

Is there a pattern when these stocks tend to turn down and give back their gains? Yes. As the chart shows, the 40-50 day range is weak. The really significant time is near 80 to 85 days after trading begins.

Why These IPO Stocks Tend to Pull Back

It is important to remember that only a fraction of a company’s shares actually trade at the beginning. Also, insiders and early investors want to get paid and will sell their shares when they can.

Let’s first consider the number of shares that are released for trading at the IPO date. The float in a stock’s early days typically represents a small fraction of its outstanding shares. The float means the number of shares that are actually eligible to trade hands in the marketplace. When the float is small, it is much easier for demand to push the price in either direction. For a stock with high expectations, that often means up. Notice the following percentages of stock that are released at the IPO date and lockup expiration periods:

WUBA (58.com) 14.1% of outstanding stock, lockup period 180 days; some selling allowed after 90 days

JD (JD.com) 6.9% of outstanding stock, lockup period 180 days; some selling allowed after 90 days

BABA (Alibaba) 13.0% of outstanding stock, lockup periods of 180 days and 1 year; some selling allowed after 150 days

IQ (iQiyi) 17.7% of outstanding stock, 180 day lockup period; some selling allowed after 90 days; IPO prospectus also states “the underwriters may, in their sole discretion and at any time or from time to time before the termination of the lock-up period release all or any portion of the securities subject to lock-up agreements.”

When a company’s growth prospects are good and many investors are fighting over the available shares it is much easier for price to rip to the upside. As these selling periods approach, however, many investors sell and head for the sidelines, driving prices back down.

Valuation

It is often challenging around an IPO date to get a good handle on valuation. So many things are speculative at this point. Most new companies are still losing money. They are still paying out a significant amount in stock options to their executives and new hires. They will often continue to bleed money for a few years. With negative net income a number of common valuation measures like P/E, EPS, return on equity, return on assets are all meaningless. The valuation process is more of a speculative projection of the company’s growth trajectory. It often assumes that this new company will follow the path of comparable companies that have come before it. All of this may turn out to be true or completely false. So, the company trades on hope and expectations in the early days.

Of course, analysts look at things like management experience, business model, product demand and uniqueness, competition, customer feedback, declining losses, and other efficiency measures. All of these metrics are important but continue to be speculative.

Technical Analysis

With so little trading history it is challenging to obtain a good technical picture as well. Charts can be broken down into 1-hour, 4-hour, and daily time frames. However, it takes a while to create a complete technical picture.

Key takeaways for now:

Near-term price action and wave count suggest that prices are due to correct a bit lower.

However, it is likely to be temporary.

Look for $27-$29 to offer up decent support

Targeting $39.50 – perhaps right into that 80-85 day window

What Does All This Mean?

The long and the short of trading a recent IPO stock is that it is unpredictable. In the case of a stock like IQ that has gone up very fast, it is wise to prepare for a pullback. As the chart above shows, pullbacks can last for a couple of weeks and they can be deep. The 30-45 day area is a sensitive time and the 80-85 day period is often the near-term peak as some shares unlock and traders start to prepare for the 180-day lockup expiration when executives and early investors can get paid for their hard work and investments, which they will surely do.

For traders, proceed with caution and realize that this time it probably isn’t different. This one probably isn’t going straight to the moon, just like all the others that have come before it. If you have gains, enjoy them. Wait for these pullbacks and be especially wary of the 85 day timeframe when the reality of selling pressure starts to set in.

Chinese IPOs aren’t necessarily Russian roulette but they can be volatile. Aspen Trading will continue to monitor this company’s fundamentals and technicals. We will also be watching for pullbacks and alerting clients to opportunities to re-enter the trade.

​

This is a post by our friends at the Aspen Trading Group, founded by David Floyd. To start a trial of their service,please follow this link